NUMBER 41 I JUNE 2000 The Transformation of Microfinance in Kenya The desire to achieve institutional and financial sustain ability through improved governance and increased profitability has resulted in the transformation of one of Africa's most successful microcredit programs into Kenya's first commercial microfinance bank. Despite considerable strategic, operational, and regulatory challenges, there is now the potential to access additional sources of capital, particularly from client savings, thereby reducing dependence on donor funds, expanding market outreach, and recycling client savings to microenterprises rather than channeling them through traditional banks to finance wealthier sectors of the economy. This transformation will also facilitate the provision of additional financial services to low-income populations. The Kenya Rural Enterprise Programme (K-Rep) was established in 1984 by World Education, Inc., a United States based private voluntary organization, with funding from the United States Agency for International Development. It is now one of the most innovative and successful microfinance schemes in Africa. K-Rep provides financial services to the poor who are typically excluded from the formal financial sector, thereby generating income and employment opportunities for low-income people. In 1994, K-Rep decided to transform its microenterprise credit program into a commercial bank. Five years later, K-Rep has just completed the process of institutional reorganization and diversification. It has: 1) changed its name from Kenya Rural Enterprise Programme to K-Rep Holdings Limited; 2) split its microenterprise credit operations from its research and advisory services, creating K-Rep Bank Limited; 3) received a banking license in March 1999; and 4) secured share capital in K-Rep Bank. 111.1+".' Eqllity And Growth tll'Ivllgh £'conomir Researrh­ an activity oj U.SAlD, Bureau Jor Afrim, OJficf oj Sustainable Devflopmmt, Strategir Analysis [)iv ~5ion Profile of K-Rep Bank K-Rep gross income more than Throughout its history, K-Rep has quadrupled from 1991 to 1998, learned from doing. It began as an increasing from KSh 39.9 million to KSh intermediary NOO that provided on­ 180.8 million. Of special note is K-Rep's lending, training, and technical assistance declining dependence on grant income. to local NOOs. Concerns about sustain­ In 1993, grants comprised 87 percent of ability and effectiveness of its NOO K-Rep's income, but grants had fallen clients prompted K-Rep to start its own to 32 percent of income by 1998. Most direct lending program in 1990. of this grant income has been replaced K-Rep's two direct lending products, by income from credit schemes and luhudi and Chikola, both started out as miscellaneous income (primarily interest hands-off group lending schemes on treasury investments and income from modeled after the Orameen Bank in consulting services). Bangladesh. Over time, the model was adapted to Kenyan conditions. In 1994, Strategic Issues K-Rep ceased all wholesale lending to The creation of K-Rep Bank raises two NOOs due to increasing arrears, and key strategic issues: 1) How will K-Rep combined the administration of luhudi Bank's need to be commercially viable and Chikola loans for greater operational and institutionally self-sustaining affect efficiency. It adopted a 'minimalist' credit its current microbanking mission and approach,emphasizing financial services. market niche? 2) What are the potential complementarities and contradictions K-Rep has experienced substantial in the missions of K-Rep Bank and growth in the 1990s. The number of K-Rep Holdings? employees has increased four-fold, from 39 in 1991 to 152 in 1998, and the Commercialization and number of distribution outlets has grown Corporatization of K-Rep Bank from two area offices in 1991 to five area offices and sixteen field offices The experience of microfinance NOOs throughout Kenya by 1998. K-Rep elsewhere that try either to attain lending has also grown dramatically over commercial viability as NOOs or to the past eight years, increasing almost transform themselves into banks, is that eight-fold in the number of loans financial pressures compel them to make disbursed annually, and increasing larger loans than they had made twenty-four fold in the value of previously. The motivation is clear: the loans disbursed annually. K-Rep more lent per loan officer, the lower the made 1,507 loans totaling KSh 14.3 cost per unit lent. While this has not million in 1991, which had grown necessarily led to a deterioration ofIoan to 11,582 loans totaling KSh 347.1 portfolio quality, it has led to a re­ million disbursed in 1998. With the examination of the microfinance exception of 1994 and 1995, loan institution's mission and that institution's repayment rates have remained high at current market niche. between 96 and 99 percent. Until recently, the trend at K-Rep had been increasing average loan sizes. This EAGER Policy Brief trend alarmed K-Rep management, as making it more difficult for K-Rep Bank default rates were higher for the larger to benefit from K-Rep Holdings' loans in K-Rep's portfolio. However, the innovations. average K-Rep loan has decreased over the past year and a half due to K-Rep's Operational Issues "back to basics" policy of refocusing The creation of K-Rep Bank raises attention on lower-income borrowers, three critical operational issues: 1) How both to better achieve K-Rep's mission, will K-Rep Bank mobilize voluntary and to improve credit risk management. savings, and what will be the relationship between voluntary and mandatory Potential Complementarities savings? 2) How can K-Rep Bank and Contradictions of K-Rep Bank improve the efficiency while maintaining and K-Rep Holdings the quality of its lending operations? An important strategic challenge for 3) How can K-Rep Bank ensure K-Rep Bank and K-Rep Holdings is to sustainability? foster synergies created by their complementary core competencies, Savings Mobilization while minimizing the effects of different The mobilization of voluntary savings institutional functions. The K-Rep in successful microfinance institutions Group Coordination Office should depends on easy access to one's deposits, facilitate interactions between K-Rep the perceived safety of these deposits, Holdings and K-Rep Bank. and a fair return on funds deposited in the microbank. In marketing savings The most important synergy between products not tied to borrowing, K-Rep K-Rep Bank and K-Rep Holdings is the Bank's license and concomitant deposit Bank's integration, or adaptation and insurance might satisfy consumer commercial replication of K-Rep demands for safety, and a market interest Holdings' microfinance innovations to rate might meet consumer requirements enhance K-Rep Bank's outreach and for a fair return, but there is still the coverage. The challenge will be to danger that K-Rep's well-known policy make use of banking products and of requiring mandatory savings as a delivery systems developed by K-Rep condition of borrowing might lead Holdings, such as the Financial Services potential savers to doubt the accessibility Associations (village banks), in a finan­ of their voluntary savings, despite K-Rep cially viable manner. The area most Bank's assurances. likely to cause confusion in terms of overlapping and competing functions is Cost-Effectiveness the simultaneous delivery of microcredit via both K-Rep Bank and K-Rep of Credit Operations Holdings. To avoid such a conflict, K-Rep has developed a successful K-Rep Holdings and K-Rep Bank are methodology for delivering credit to currently working in different geograph­ entrepreneurs who previously did not ical areas and targeting different clients. have access to formal credit institutions, This has had the unintended effect of and ensuring that most of these loans are POLICY BRIEF 411 JUNE 2000 paid back on time and in full. Over time, prudential regulation and supervision K-Rep Bank must increase the amount of microfinance banks in Kenya: lent per credit officer, by increasing 1) Are the CBK's commercial banking either value (making larger loans) or statutory requirements and prudential volume (making more loans). The key norms and regulations appropriate is to achieve economies of scale in a for microfinance banks? 2) Can the CBK manner that balances the greater credit monitor and enforce these provisions risk of larger loans with the higher in a cost-effective manner for micro­ transaction costs of smaller loans. This finance banks? will entail a re-examination of current credit operations to determine which Regulation and Supervision attributes are intrinsic to K-Rep's success of K-Rep Capital Adequacy to date, and which characteristics can At a minimum, microfinance banks be modified for increased cost­ should be subject to the same capital effectiveness. adequacy requirements as general commercial banks. The CBK might also Ensuring Sustainability consider making these requirements K-Rep Bank must continue to charge even more stringent for microfinance its borrowers enough to cover its costs banks, given the relatively faster and generate a profit for its owners to and larger impact losses have on a ensure institutional sustainability. In this microfinance bank's capital base. context, its main concerns will be to see that product pricing still covers lender Asset Quality transaction costs, the cost of loanable The CBK should require microfinance funds, and provisions for bad debts, loans to be classified by time overdue in while at the same time trying to keep keeping with the prevalent repayment these costs to a minimum. period for a microfinance bank's loans, and loan provisioning implemented Regulation and Supervision using a rules-based, non-discretionary Issues system based on historical performance Issuance of K-Rep's banking license and periodic sampling of arrears, and raises regulation and supervision regardless of collateral pledged.